New Year, A New Start for EM? Not Exactly

 

JANUARY 21, 2016 [OIL, CHINA]
Charles Wilson, PhD


Emerging markets have tripped out of the gate in 2016, tangled in some of the same concerns that dragged down performance last year. But valuations have now become even more attractive.

After a very difficult year in emerging markets in 2015, we entered 2016 cautiously optimistic about returns. So far, the markets are off to a difficult start with the MSCI Emerging Markets Index already down more than 10% and many developed market indices not doing much better. The same ingredients for market instability we saw in 2015 have again jumped to center stage: China growth concerns and commodity prices. With oil prices weakening over the last two years and China’s slowdown and economic transition well telegraphed, we asked ourselves what has changed since January 1 to drive equity prices lower.

As we have written previously, the world is producing too much oil. North American independent oil producers got the oversupply memo a little late and perhaps were a little slower to act than they should have been. They are being forced to act now as cash flows turn negative and they lose access to new sources of funding via fresh debt or equity issuance. According to Baker Hughes rig count data, the North American rig count has fallen over 60% from highs in late 2014. The lower rig count has lead to a drop in U.S. production, with continental U.S. production falling from just shy of 9.2 million barrels per day (mb/d) at the peak to 8.7 mb/d currently. Unfortunately, that lower production has stabilized and actually increased since October by about 100,000 b/d due to new Gulf of Mexico capacity. To make oil market matters worse, economic sanctions against Iran have been lifted as part of last year’s nuclear deal. Industry analysts estimate that Iran has close to 50 million to 60 million barrels of oil in floating storage offshore that is expected to come to market immediately. In addition, Iran has announced publicly that it wishes to increase its production by 1.0 million b/d by the end of 2016, although many international oil analysts are skeptical of Iranian production potential given recent underinvestment due to impact of the international sanctions.

North American Rig Count

North American Rig Count

Another factor weighing on oil prices has been the recent equity and currency market volatility observed in China. Chinese officials quickly cancelled their newly instituted equity market circuit breaker guidelines after it became clear that the circuit breaker program was encouraging rather than deterring panic selling. This is another misstep in a long list of recent intervention missteps that has usually been accompanied with poor external communication about their intentions. Unfortunately, after a few days of limit-down price action, the damage had been done to global investor sentiment toward equity markets, and confidence in the Chinese government’s ability to manage its current economic slowdown. Currency markets followed the lead set by the Chinese equity markets with a quick 2% drop in the offshore RMB/USD.

A lot has happened but has anything changed that would warrant a 10% drop in global equities and a nearly 25% slide in oil prices since the start of the year? If you step back, much of the seemingly “new” information was actually well known and widely discussed. The International Energy Agency was openly discussing Iran’s excess capacity and floating inventory through most of the back half of last year. It was also very vocal about the need to see further supply cuts primarily from the North American onshore producers. There is nearly unanimous agreement among industry analysts that the global oil market will remain oversupplied through at least the third quarter and likely the fourth quarter. Those expectations remain largely unchanged since December. There is no question China remains an important driver of oil demand growth and significant devaluation of the RMB could strain their collective buying power, but despite the early volatility the renminbi has only declined about 1% over the first three weeks of January. It’s definitely been a bumpy ride but Chinese buying power is largely unchanged since the start of the year.

In some respects I think this is a case of market prices infecting estimates of valuation for stocks rather than earnings fundamentals driving stock returns. Historically, emerging markets have moved in tandem with oil prices. While the correlation would be expected for oil and commodity exporters like Russia as well as many Middle East and Latin American countries. It makes a lot less sense for most countries classified as emerging markets because they are actually net oil importers. Looking at the current composition of MSCI EM, only 19% of the total index weight are equities based in countries which are net exporters of oil. If you broaden that to include net commodity exporters, the weight increases to just shy of 30%. Why then is EM so tied to oil prices? The likely answer has to be the correlation between growth expectations and oil prices. Normally a drop in oil prices signals a slowdown in demand, which is almost always due to faltering economic growth. One of the main drivers of emerging market growth over the last 15 to 20 years has been global trade. A fall in oil prices has become a good signal for a drop in global trade activity. One thing to note is that weak global growth over the last five years has helped to wean emerging markets off the easy growth model of exporting deflation via cheap labor costs. Many countries have turned inward in an effort to find a sustainable growth model built on domestic demand. We find this transition in growth to be much more attractive and sustainable and potentially a recipe for a long-term valuation multiple rerate.

This time we have a false positive. China’s currency is likely to weaken but we don’t think it will be dramatic. China’s equity markets are not contagious—mainland listed “A-shares” aren’t even included in the benchmark MSCI EM Index—and China’s capital account remains mostly closed. Global growth, while weak, is positive, and is widely expected to exceed 3% this year. The drop in oil prices is simply due to too much oil supply—not weak demand. If anything, oil demand has continued to surprise on the upside, even as global economic growth has struggled to improve. Oil demand is one of the few growth indicators seeing positive revisions. While we thought the decline in emerging market equity prices last year provided an attractive entry point, we think the entry point just became a little more attractive.

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