Doha: Rising commodity prices are generally a major tailwind for emerging markets (EM). In fact, the positive relationship between commodity cycles and capital flows to emerging markets, which benefits macroeconomic growth in boom cycles, has been held in different forms for centuries.
High and rising commodity prices often cause a positive feedback loop in emerging markets, which improves external accounts, appreciates the local currency, increases government revenues and strengthens credit ratings. This stimulates the expansion of emerging market credit and overall GDP growth.
In principle, this should be great news for EM in this time of recovery from the COVID-19 pandemic. At the time of writing, the Bloomberg Commodities Index is up 56% from March 2020 lows and 15% from pre-pandemic highs last year. Metal and mineral prices have returned to levels last seen over a decade ago during a major commodity boom, while agricultural products are also hitting new multi-year highs.
However, the usual synchronization between commodity prices and emerging market assets, which lasted from March to the end of 2020, is clearly breaking down. While commodity prices have risen 17% so far this year, the MSCI EM Index, which captures large and mid-cap stocks from 27 different emerging markets, has fallen more than 5% over the past year. the same period.
In our view, there are three main factors behind this unusual price divergence. First, emerging market real interest rates, which adjust the nominal interest rate for local inflation, have fallen relative to US real rates. This is negative for emerging markets as real interest rate differentials are a major driver for capital flows as investors seek to allocate their resources in assets with high risk-adjusted real returns.
While inflation in emerging markets, particularly Latin America (LATAM), Asia and the emerging Europe and Africa (EMEA) region has increased since the start of the year, central banks in emerging markets have not have not yet fully adjusted interest rates to adequate levels. This causes a widening of the real gaps between emerging markets and advanced economies.
Second, the economic recovery in emerging markets has been weaker than the US recovery, especially in middle and low income emerging markets. This is mainly due to slower mass vaccination campaigns which prolong the pandemic in emerging countries and less political space to stimulate the economy during the recession. With weaker central banks and fiscal institutions, and with a smaller capital base to tap into, most emerging markets did not have the conditions to support their households and businesses in the same way as advanced economies. As a result, while economic authorities have shielded the private sector balance sheet from the pandemic crisis in the United States and other advanced economies, the same has not been true for most emerging markets. As a result, consumption and investment will be relatively slower to recover in most emerging markets, even in a context of rising commodity prices.
Third, despite rising commodity prices, there have so far been no major improvements in the trade balance of non-energy emerging market commodity exporters in recent quarters. This is partly due to the fact that the prices of manufactured goods have also risen, due to supply constraints and a boom in demand for electronics, which is weighing on the import bill of raw material exporters. This negatively affects the current account balances of emerging countries and the reserves available for monetary or fiscal support, preventing a faster economic recovery.
Overall, real interest rate differentials, relative economic performance, and strong demand for manufactured goods prevent most emerging markets from benefiting further from rising commodity prices. That could change soon if high commodity prices persist as emerging market central banks take a more hawkish stance against inflation.