The impact of commodity prices on Emerging Markets

After a lengthy period of stability, global commodity prices have fallen sharply. What began as a decline in food prices has morphed into a broad-based decline, led more recently by oil prices. The Reuters/Jefferies CRB index, a daily measure of 19 commodities of food, energy and metals, has fallen 12% since the end of June.

In this Anchor Report, our emerging market (EM) country economists highlight the various channels through which EM economies are affected by lower commodity prices, from merchandise trade and inflation to fiscal positions and GDP growth. Of course, how a drop in commodity prices impacts an economy also depends on the idiosyncrasies of individual countries. Among others, these include: 1) the (geo) political cycle (e.g., Brazil, Ukraine, Russia and Indonesia); 2) the scope for policy responses; 3) movements in exchange rates; and 4) the initial starting conditions regarding growth and strength of economic fundamentals.

Commodity prices are always tricky to forecast; in determining their economic impact it matters greatly how long the shock lasts and whether it is more demand- or supply-side driven. This explains why economists are hesitant to quickly change their forecasts amid commodity price shocks. With this in mind, the approach taken in this report is to use our EM economic forecasts from mid-October – a point at which we had largely not altered our forecasts due to the increasing commodity price drops – as the baseline.

Against our baseline and to allow for unique country idiosyncrasies, instead of using a global macro model we use the expertise of our country specialists to conduct our own ‘what if’ scenario analysis: what if the recent broad-based decline in commodity prices is sustained through 2015 and driven significantly by deficient demand?

Specifically, in this scenario we use the CRB commodity price index and assume that on top of its near-10% drop in Q3, it falls by a further 10% in Q4 (so far it has fallen 3%) and then stays at that end-2014 level through the whole of 2015 (implying a 12% drop in 2015 versus 2014). The scenario assumes that weakening global aggregate demand is an important driver of the sustained drop in commodity prices, with 2015 global GDP growth of only 3.0% (compared to our baseline of 3.6%) and 2015 China GDP growth of 6.0% (compared to our baseline of 6.8%).

From a big-picture macro perspective, the following economies stand out as clear winners (i.e. benefit the most) and losers, in no particular order:

Winners: India, the Philippines, Thailand and Turkey.

Losers: China, Hong Kong, Malaysia, Indonesia, Russia, Brazil, Colombia and Chile.

Turning to our FX and interest rate strategy views, all recommendations are highlighted in the country pages, but generally we believe there is relative value in EM FX that can be expressed through a basket of long/short currencies. The bias to receive rates is broad-based in EM.

In our scenario of a demand-driven, sustained drop in commodity prices, our strongest convictions (note that these are not necessarily our current recommendations; they are our best trades under our ’what if’ scenario) are:

• Long 3M TRY/MYR is a strong conviction recommendation in our risk scenario. The trade could see total returns of 9.8% based on our end-2015 FX forecasts in the risk scenario and current FX forward rates.
• Buy 5Y Turkey government bonds, targeting a 100bp rally to 7.5-7.75%.
• An EM FX basket of long 3M TRY, INR and PHP against short BRL, MYR and COP. This equally weighted basket captures our key regional divergence views and in our scenario could see a total return of around 5.9% by end-2015.
• Receive Poland 5Y IRS. 5yr rates lower by around 50bp to 1.5%
• Long India bonds (IGB 8.12 2020) targeting 8.00% (8.43% currently)
• Receive THB 1yrfwd2yr targeting 2.15% (2.38% currently, 3M roll: 9.5bp)
• Mexico 5s10s TIIE steepener.