Post-crash Scenarios for Commodities and ‘Turbo-coupled’ Emerging Markets

According to Ignatius Chithelen, managing partner of Banyan Tree Capital Management, an investment firm in New York City, emerging markets are not de-coupled but rather “turbo-coupled” to developed markets. In this opinion piece, Chithelen describes what he sees on the horizon for emerging markets and for commodities prices in the wake of the global economic crisis. Among his predictions: China will likely emerge as the big winner from the current worldwide recession, and Mexico’s recent hedging of its oil exports will lead to a cap on commodities prices over the short to medium term.

The recent global financial and economic collapse, due to the credit freeze triggered by Lehman Brothers’ bankruptcy in September, has again revealed that emerging stock markets are not de-coupled but rather “turbo-” or “hyper-coupled” to those in the developed world, primarily the United States. In November, when the S&P 500 Index had fallen by half from its 2007 high, the MSCI Emerging Markets Index fell by a sharper 70%. Since last summer, panicked U.S. and European investors have been selling and bringing their money home, causing a steeper collapse in the relatively less liquid emerging markets. Similarly, on the upswing, while the U.S. stock index rose by about 80% from 2003 to its 2007 peak, the emerging markets index shot up by about 400%, driven by inflows from U.S. and European funds.

Why Turbo-coupling?

Often times, including in the current situation, stock markets serve both as a barometer and determinant of economic well-being in developed and emerging markets. Also, for most companies in emerging markets, except China, it is investor confidence or greed in developed countries that largely determines the ability to raise capital.

For instance, during the 2003-2007 bull market, despite weak domestic interest, Brazilian companies were able to raise billions of dollars only because U.S. and European investors eagerly bought more than 70% of their stock offerings. In India, foreign funds account for more than 20% of the daily stock transactions, in effect influencing both the direction of the stock market and also the specific winners and losers. In the case of bonds, California based PIMCO, the world’s largest bond fund manager with US$790 billion in assets, is said to dictate the yield, maturity, collateral and other terms of emerging market issues, especially those from the smaller countries. It is hence not surprising that financial markets in emerging countries, and to an extent their economies, have not de-coupled but are turbo-coupled to flows from the U.S. and other developed markets. 

With global financial markets stabilizing since mid November, trillions of dollars being pumped into recovery efforts by the U.S. and other governments, and the benefits of lower oil and other commodity prices, there is likely to be a fresh run-up in developed stock markets. Given the turbo-coupling, whether this rebound is short-term or long-term, it could likely lead to a sharper upswing in emerging markets. But in contrast to the near uniform rise across major emerging markets from 2003 to 2007, this time they are unlikely to all move up in sync.

Oil and Other Commodities

Part of the reason is the rapid decline in oil and other commodity prices. In January of 2008, oil prices have hovered around US$40 per barrel, the lowest level since 2004. This is due to falling demand amid the global recession and doubts over whether OPEC’s proposed supply cuts will be fully implemented. Some low-cost producers will pump as much oil as they can, to try and capture more dollars through higher volume at the lower prices. Nigeria, whose government uses US$45 oil to prepare its budget, initially opposed OPEC’s proposed cuts in supply. The energy minister of this major, low-cost oil exporter told The Financial Times on November 21, “If you cut the volume, then it is going to affect your budget … [A] cut … is not in our interests.”

In addition, hedging by Mexico — and possibly other exporters — is also responsible for the recent weakness in oil prices. On November 13, it was reported that Mexico hedged its crude oil exports for 2009 at prices ranging from US$70 to US$105 per barrel. It exports about 1.7 million of its 2.8 million barrel-per-day oil output mostly to the U.S. Mexico was then estimated to have already gained more than US$10 billion on the hedge, for which it is said to have paid US$1.5 billion between July and October of 2008.

After Mexico’s hedging was disclosed, crude prices tumbled further, from about US$70 to a January low of around US$35. While global demand has softened since November, evidently the oil market also reflects expectations that other low-cost countries are hedging their exports. Kuwait, UAE, Algeria and Qatar — in addition to Nigeria — are among major exporters who can balance their budgets and foreign trade with oil prices of US$50 or lower.

Saudi Arabia, the swing producer which rules OPEC due to its relatively large excess capacity, is estimated to need US$43 oil to meet its current budget and trade requirements. In the mid 1990s, the Saudis flooded the market with oil, pushing its price down to US$10 by 1998. This severely hurt the economies of the higher-cost oil exporters like Mexico, Iran and Venezuela, which were ignoring OPEC’s and Saudi Arabia’s dictates to cut supply. The price collapse forced them to strictly abide by new supply cut agreements and — with Norway, too, cutting output — oil prices climbed back up.

Today, besides Mexico, other major exporters including Russia, Iran and Venezuela are estimated to need oil prices of US$70 or more to support their economies. The supply decisions of Saudi Arabia, given the geo-political context and its own economic requirements, are likely to be another key factor in determining medium-term oil prices. Saudi Arabia is estimated to be currently producing around eight million barrels per day, down from 9.7 million barrels during the summer of 2008. Thus, reflecting its clout, it alone accounts for 77% of the 2.2 million barrels-per-day in cuts announced by OPEC in December.

Saudi officials have recently stated they would be content with oil prices around US$70. If oil prices were to rise to around US$65 in the near future, some major low-cost producers will likely hedge their future exports to lock in gains and preempt hedging by Mexico and other higher-cost producers. So, due to Saudi supply actions and the hedging by low-cost producers, any oil price rise is likely to be capped around US$65 until global demand picks up strongly or there are major supply shocks. One major shock could be Mexico’s inability to meet its oil export obligations under its hedging contracts. Mexico’s oil output has been declining for more than a decade and fell by 9% in 2008.         

While oil is the major commodity, it is likely that low-cost producers of copper, soybeans and other commodities with liquid futures markets have also hedged to lock in higher prices for their future exports. Mexico’s disclosure of its oil hedging reveals that there will likely be a cap on prices of major commodities near or just above their current levels, down sharply from their 2007-2008 peak prices. Any upward spike in prices in the near future will likely see low-cost producers putting on new hedges, thereby bringing prices back down. The level and strength of the price ceiling will depend on supply-demand imbalances for the commodities, the actions of swing producers and severe supply shocks, if any.

Losers and Winners

Obviously, lower prices are hurting commodity exporters like Brazil and Russia and benefiting China, Japan and other importers. In the case of Russia, while it has an estimated US$540 billion in foreign currency reserves, it has had to rescue some of its major banks which were choking on US$100 billion or so they have borrowed abroad in recent years. In all, companies in emerging markets borrowed about US$1 trillion from lenders in developed countries over the past three years. Some US$110 billion of that is due in 2009, including from Brazilian and Indian companies.

China is best positioned to emerge stronger from the current global crisis. If oil prices stay around US$40, China’s annual benefit will be about US$70 billion — or about 2% of its GDP — over its 2007 costs. This is due to the lower price on the four million barrels of oil a day it imports, roughly half its total consumption. In addition to gaining from lower commodity prices, China has more than US$2 trillion in foreign currency reserves and a budget and trade surplus. Given that it needs export growth and over 7% in real GDP growth to avoid internal social unrest, China is actively working with the U.S. and others to defuse the current crisis, including announcing its own US$586 billion domestic stimulus package in November.

More Outsourcing

During the 2000-2002 downturn, companies cut costs by slashing staff and closing plants in the U.S. and the European Union and moving operations to low-wage emerging countries. Manufacturing moved to places like China and Mexico while information technology and service jobs were outsourced mostly to India, creating big winners for businesses and investors who were early in foreseeing this trend. Until late 2007, it was the appeal of outsourcing that provided the major rationale for investing in emerging markets. Reflecting this, for instance, stock certificates of Indian outsourcing companies in the U.S. traded at 50% plus premiums to their underlying share price in the Indian market.

In the current downturn too, companies in the U.S. and the EU will seek to outsource jobs to low wage emerging countries. Besides possibly more manufacturing jobs moving or being set up in China, this time it may be more difficult to pick other major winners. Given years of outsourcing, how many office jobs are left in the U.S. and EU that can be outsourced? Is there still enough of a cost-benefit advantage, assuming similar quality, from moving such jobs to an emerging market? Will the governments in the U.S. and EU permit loss of jobs when domestic unemployment is rising rapidly? From an investor’s viewpoint, what is the level of extra capacity built up in recent years by outsourcing businesses, including in IT in India, when access to cheap capital was very easy?  

Importance of Politics

There is debate over whether a global financial and economic rebound will be temporary, to be followed by another collapse sometime in 2009. An additional US$1 trillion or more in losses from the fall out of the U.S. housing and mortgage mess needs to be recognized by banks and other institutions worldwide. This is on top of the roughly US$1 trillion in losses that have already been taken so far.

The other worry is over what happens in the political and policy arena, not just in emerging markets, but also in the U.S. and other developed countries. Up until September, political analysis focused mostly on risks in emerging markets. In addition to political stability, the issues of concern were things like whether a change in government will lead to policies that hurt foreign business interests, as happened in Bolivia, or hurt foreign financial investors, as in Thailand.

But few analysts anticipated that the U.S. administration would let a major financial player like Lehman go bankrupt in September, causing the freeze in global credit markets in its wake. Also widely unexpected was that soon thereafter, the U.S. Congress would initially reject the financial rescue package, despite President Bush’s backing, leading to a further plunge in global financial markets. Now, among the areas of friction to watch for is China’s trade surplus with the U.S. and EU, and growing calls to protect jobs in the developed countries from imports and outsourcing.

So investing in emerging markets based on the unified concept of BRIC — Brazil, Russia, India and China — is faulty, even though billions of dollars were raised by BRIC-dedicated funds in 2006 and 2007 using this catchy marketing phrase. The conditions point to the likelihood of a broad-based, short-term, turbo-charged bounce in emerging financial markets, tied to an upswing in the developed markets. Over the long term though, a country’s economic and financial condition, commodity prices, politics and a company’s ability to grow revenues and margins will determine winners and losers in emerging markets, also in a turbo-charged manner.

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