What Weak Commodities Mean for Emerging Markets

Weak Commodity Prices Put Pressure on Emerging Markets

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Commodity prices have moved sharply lower throughout 2015 and 2016 amid China’s economic slowdown and the rising U.S. dollar valuation. With the rising production of crude oil and agricultural commodities, prices are expected to remain weak for the foreseeable future as the global economy struggles to regain traction. Investors have an interest in these trends on both the commodity level and in terms of countries that have exposure to the commodities.

In this article, we’ll take a look at what weak commodity prices mean for many emerging market economies that are dependent upon them.

Determine Commodity Exposure

Emerging markets tend to be grouped into the same basket by international investors, but their exposure to commodities ranges considerably. Countries like Brazil have substantial commodities exposure that ranges from crude oil obtained through its quazi-governmental Petrobras to iron-ore produced by billion-dollar publicly-traded companies like Vale SA. But other countries, like India are better-known for their technological prowess than commodities.

International investors should carefully examine their emerging market holdings when determining how much exposure they have to commodities. The easiest way to analyze exposure is to look at the holdings of country exchange-traded funds (“ETFs”) to see how much allocation is given to Basic Materials relative to other industries.

Often times, this data can be easily found in a fund’s prospectus or website or through third-party websites like ETFdb.com or ETF.com. 

Analyzing Commodity Performance

All commodities shouldn’t be treated the same, since each has a different supply and demand dynamic at various points in time. For example, canola and ethanol were both strong performers between mid-2014 and mid-2015, despite the widespread decline in many other commodities like crude oil and precious metals.

There are also performance differences between classes of commodities, such as energy, agriculture, or metals, depending on various macroeconomic factors.

International investors should carefully consider their exposure to specific commodities, as well as commodities in general. While these dynamics can be more difficult to determine, the equity component of many country ETFs provide a hint as to specific commodity exposure. An investor might look at the iShares MSCI Brazil ETF (EWZ) and see that Petrobras accounts for about 3.47% of the total allocation, which means that crude oil exposure is relatively high.

Hedging Commodity Exposure

International investors looking to address commodity exposure within the emerging market component of their portfolios have many options. The first option is to simply sell exposure to commodity-focused emerging market equities in order to reduce their exposure. While this may effectively reduce future exposure, the sale of stock may generate capital gains taxes and come at an inopportune time.

Investors that aren’t looking to sell their positions may instead want to consider buying stock options to hedge their exposure. By purchasing put options, investors can establish a floor for their position and offset any future losses without actually having to sell the equity position.

The benefit is that no capital gains taxes are incurred and there’s little risk of missing an unexpected recovery in commodity prices, although a slight premium is paid.

In general, most financial advisors recommend only modest exposure to direct commodities and diversification across both emerging and developed markets. Investors that remain diversified face less risk associated with a decline in any single commodity or commodity-dependent country and tend to realize higher risk-adjusted returns over time.

Key Takeaway Points

  • Commodity prices have a big impact on certain emerging markets, which could in turn have an impact on international investors’ portfolios.
  • Investors should begin by assessing their exposure to emerging markets and then determine which commodities have the greatest impact.
  • There are many different ways to hedge against declines, including outright sales or purchasing put options to offset losses.
  • Investors should carefully consider all of their option before making a decision in order to enhance their long-term risk-adjusted returns.